[We're All Keynesians Now]
Part 3 [previous]
Fiscal Policy
I know most of you have been bored to death by my lectures on the stimulus bill currently making its way through the House and Senate,6 but I can't say it enough: there simply is no stimulus in this package. There is no Keynesian multiplier. In 1971 the University of Chicago'’Äôs Journal of Business published my paper, "A Formal Model of the Economy"7 in which I researched quarterly government spending and purchases of goods and services data for any possible multiplier effect. I found there is a one-period stimulus equal to the size of the increase in government spending, followed by three quarters of crowding out, which causes GDP to fall back to where it otherwise would have been. The net effect, of course, is a zero multiplier for government spending. All that happens is government spending replaces private spending. And we found that transfer payments, which this bill is loaded with, actually reduce GDP and GDP growth. Things haven't changed since then.
I want to go through the logic of the stimulus and how it works to better explain the theory behind the current administration's fiscal policy. Larry Summers describes it this way: if you give a guy $600 that he otherwise would not have had, he is going to spend more than he otherwise would have spent. And that's true; he is going to go out and buy stuff. That in turn is going to create jobs for people who are now supplying him with the goods and services he otherwise would not have bought. Those people in turn will have higher incomes and spend more money, and there will be this cascading effect through the economy. And that will lift the economy up by the bootstraps. In macroeconomics this is what they call the spending multiplier effect. There are arguments about just what the multiplier is on increased government spending, but we'll get to that later.
The Larry Summers description is correct, but that’Äôs not the whole truth; it's only the first chapter of the story.
The second chapter is that unfortunately, when the government gives control over real resources to someone based on some characteristic other than work effort, it must take those resources from someone else. It is a zero sum game. The government can redistribute income but not create it out of thin air. By giving resources to one group and taking them from another, the taxpayers who lose resources in turn will spend less. That will dis-employ people who had heretofore been employed supplying them with the goods and services they are no longer buying. The incomes of the newly dis-employed people will be down, they will in turn spend less, and there will be a cascading effect through the system on the other side that exactly offsets the multiplier effect on the stimulus recipients.
For every dollar received there is a dollar lost. That's double-entry accounting. The income effects in an economy always net to zero. This is just math, not ideology. It's not left wing or right wing, Republican or Democrat, liberal or conservative, just plain economics and math.
If you don’Äôt believe me, go back and sum the Slutsky equations in an economy and you will see that the income effects net exactly to zero. This was brought into economics by Lˆ©on Walras, the French economist, and translated into English by Lord Hicks in his book Value and Capital. Walras gives an excellent example. If the price of apples rises, apple growers will be wealthier and have higher incomes and spend more. But apple consumers will be poorer, have lower incomes, and spend less. The income effects in an economy net to zero.
Pushing it a little bit further, to give a group of people $100 billion you usually have to raise $130 billion, whereby the extra $30 billion is the toll for the troll. To put income into one group's hands as a stimulus, the resources necessary to generate that income will have to come from people who will reduce their demand and dis-employ people, and the income effects will net to zero. There is no stimulus to the stimulus package, period.
But there is still one more chapter: the substitution effects accumulate across the whole process. If you transfer real resources to people based on some characteristic other than work effort, thoseresources can only come from workers and producers. Whenever you transfer resources, you drive a wedge between wages paid and wages received, providing less incentive to workers and producers. They will withdraw their services from the labor force, and the substitution effects will accumulate. You find that, in fact, the stimulus package not only doesn't stimulate but actually hurts the economy.
Back in 1974, I was testifying before the Senate Finance Committee regarding Gerry Ford's tax rebate, which was exactly the same thing. I was having the hardest time trying to explain the substitution effects to Senator Gaylord Nelson (D-WI). Finally I just said, "Senator, if giving $600 to people is such a good idea, why stop there? Let’Äôs transfer 100% of GDP, so everyone who doesn't work or produce receives everything, and all those who work and produce receive nothing. What do you honestly think would happen to GDP?" And his comment was, "It would go to zero." That is true.
The whole theory that these people are espousing revolves around the notion that the people who receive these funds will be stimulated into working and consuming, which is true. But they never look at the people from whom those resources are taken, who will be de-stimulated. Income effects net to zero in a closed economic system. Robert Barro wrote a great article in the Wall Street Journal on the subject recently. John Taylor also wrote one, and I wrote one a few months ago, opining on my view of the proposed stimulus package.8 There are lots of professional economists who think that not only is there no stimulus in this package but that it literally will hurt the economy. The discussion is ancient. The Gwartney and Stroups 1983 article, "Labor Supply and Tax Rates: A Correction of the Record," discusses in great detail how income effects net to zero.9 But while income effects net to zero, substitution effects accumulate.
If you give people command over real resources based on some characteristic other than work effort, those resources can only come from other workers and producers. So every time you make a transfer payment, remember there is no tooth fairy. Every dollar spent to bail out some bank or group must come from workers and producers. It drives a wedge between wages paid and wages received and actually reduces the amount of pay going to people who produce. This equates to a movement downward on the supply curve, which reduces output, employment, and production. So these packages not only do not stimulate but actually hurt the economy! And that's why I believe tax rates will rise, GDP will fall, and profits as a share of GDP will fall.
What Obama and this Congress are doing is the antithesis of what happened under President Clinton. Under Clinton, government spending as a share of GDP fell by almost 3.5 percentage points (Figure 6). It is amazing. Government spending fell by more under Clinton than the next four best presidents combined. The kind of profligate spending we're currently witnessing is exactly what happened in Japan, and we all know how well that turned out.10
The magnitude of it is simply astounding. It began with Larry Summers' first $170 billion stimulus package last February. Then there was the AIG bailout of about $165 billion, the Bear Stearns asset swaps, the government guarantees of Fannie Mae and Freddie Mac liabilities, which are approximately $5.5 trillion, so if you had a 10% default that would be about $550 billion. After that came the passage of the Troubled Asset Relief Program (TARP) at a price tag of $700 billion, and now you've just had the passage of this stimulus package at about $800 billion. Add this most recent legislation to the projected budget deficit of $1.2 trillion, and you start to get a sense of the enormous increase in federal, state, and local government debt. This massive increase in liabilities will serve only to increase future tax rates and dramatically slow economic growth. And by the way, I'm not even mentioning things like Social Security, civil service retirement, Medicare and Medicaid, the Pension Benefit Guaranty Corporation, and state government debt, which I'll cover more when I discuss California.
Remember that the stock market is forward-looking, not backward-looking. And every time another package is announced, the stock market heads further south. This is very bad fiscal policy, and about as far away from the ideal state as just about anything I have ever seen.
6. The $787 billion American Recovery and Reinvestment Act of 2009 passed both the House and Senate on Friday, February 13, 2009, and was signed by President Obama on Tuesday, February 17, 2009.
7. Arthur B. Laffer and R. David Ranson, "A Formal Model of the Economy," Journal of Business, Vol. 44, No. 3, pp. 244-267.
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